Taxmageddon 2013 Hits Dividend Income Hard – Here's What to Do

By: Money_Morning

Larry D. Spears writes: Every dividend investor loves the arrival of those quarterly distribution checks. But thanks to "Taxmageddon 2013" those checks could get a whole lot smaller.

As things currently stand - with higher tax brackets, no extension of the Bush-era tax cuts and the addition of new levies on higher-income payers to fund Obamacare - the tax bite on some dividend payments could rise from as little as 15% to as high as 43.4%.

That's dramatically higher than the possible hike in capital gains we discussed in Part One of our series on the 2013 tax outlook, which ran last Friday. By comparison, scheduled tax-law changes will increase taxes on long-term profits from 15% to 23.8% for some taxpayers.

Under the current tax laws, dividends received in 2012 are taxed in one of three ways:

•Qualified dividend income - The concept of "qualified" dividends was created by the original Bush tax cuts. It allows dividends received from domestic U.S. companies and certain foreign corporations to be taxed at the recipient's long-term capital gains rate, which is capped at 15% in 2012.
•Qualified dividends from funds - As an extension of the individual preference, qualified dividend income received by mutual funds and exchange-traded funds (ETFs), and passed on to fund shareholders, is also taxed at the individual's maximum long-term capital gains rate of 15%.
•Ordinary dividend income - Non-qualified dividends are taxed as ordinary income to the recipient, meaning they will be taxed at marginal rates ranging from 10% to 35% in 2012.

In 2013, however, three things will - or at least could - substantially boost tax rates on dividends.

That means all stock, mutual fund and ETF dividends to individuals in each of the new brackets - 15%, 28%, 31%, 36% and 39.6% - will be taxed at higher ordinary income rates. (Note: The actual income ranges for each of the new brackets has not yet been set, pending an adjustment to 2012 brackets to reflect inflation.)

Third, taxpayers in the highest marginal income brackets could be assessed an additional 3.8% "Medicare contribution tax" on their dividends, as well as on other investment income.

This new tax, authorized as part of the new Patient Protection and Affordable Care Act (PPACA), informally called "Obamacare," will be imposed on "certain unearned income of individuals, trusts and estates" and will go into effect regardless of any action on the Bush tax cuts - unless Republicans manage to repeal the entire PPACA after the November elections.

The complexity of the Medicare contribution tax rules is why we used the word "could" above. Specifically, the law says:

"For individuals, the 3.8% tax will be imposed on the lesser of the individual's net investment income or the amount by which the individual's modified adjusted gross income (AGI) exceeds certain thresholds ($250,000 for married individuals filing jointly or $200,000 for unmarried individuals). For purposes of this tax, investment income includes interest, dividends, income from trades or businesses that are passive activities or that trade in financial instruments and commodities, and net gains from the disposition of property held in a trade or business that is a passive activity or that trades in financial instruments and commodities. Investment income excludes distributions from qualified retirement plans and excludes any items taken into account for self-employment tax purposes."

Given that, your accountant will most likely have to determine whether you're subject to the new tax; we certainly can't!

However, if you are, this means your dividend income for 2013 will likely be taxed at a 43.4% rate - nearly triple the 15% rate you will owe in 2012 on qualified payouts, or 8.4% more than the maximum of 35% now due on ordinary dividends.

What You Can Do About Taxmageddon

As an individual taxpayer, there's very little you can do to mitigate the impact of this change in 2013. One is urging your Congressperson to extend the Bush tax rules and the other is trying to manage your deductions and income stream to get into a lower marginal tax bracket.

However, on the other side of the equation, if you own a closely held company that has sufficient earnings and profits, you may want to consider declaring and paying a larger-than-normal dividend to you and fellow shareholders this year while the payout will be subject to the lower rates.

Again, be sure to discuss this strategy with your accountant - and do it only if there are sufficient earnings and profits. That's because any distribution in excess of earnings and profits will reduce the shareholders' cost basis in their stock, potentially increasing their capital gain when they eventually sell - which will most likely be taxed at a higher rate at that time.

There is one thing you can do to reduce the future impact of the new Medicare tax on your dividend payouts. You can maximize your retirement-plan contributions each year, since distributions from qualified retirement plans are not included in investment income for purposes of the tax.

Be aware, however, that while those distributions aren't subject to the tax, they do increase your modified AGI. If that pushes you above the threshold, the rest of your investment income might also become subject to the 3.8% levy.

In the next installment in our tax series, we'll review the potential impact of several other scheduled changes, including a sharp reduction in allowable itemized deductions, the increases in employer withholding rates for FICA (Social Security, Medicare, etc.) and revisions to the way business owners can expense certain depreciable assets.

We'll then conclude with a review of the dozen or so other scheduled changes that will affect some or all individual taxpayers in 2013 and the years beyond.

Source :http://moneymorning.com/2012/09/13/taxmageddon-2013-hits-dividends-hard-heres-what-to-do/

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